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Komal Sri-Kumar: Inflation Story: More to Come!

The week just ended brought welcome news on the inflation front. The Bureau of Labor Statistics figures showed consumer price index were unchanged in July following a 1.3% rise in June. This brought the year-on-year increase down to 8.5% following a 40-year high of 9.1% the previous month. Just as encouraging was the 0.5% monthly decline in the producer price index compared with a small increase that had been anticipated.

But it is too soon to break open the champagne. First, President Joe Biden's claim Wednesday that "today we received news that our economy had 0% inflation in the month of July" was true only for the month, not over the past year when inflation ate up more than the increase that wage earners had earned.

Second, as the BLS report on Thursday noted, 80% of the decline in the PPI final goods index is traceable to a 16.7% fall in the price of gasoline. In context, OPEC+ members agreed earlier this month to increase production by only 100,000 barrels daily, equivalent to just 0.1% of total production, two weeks after a visit by Biden to Saudi Arabia. Clearly, this must come as a disappointment to the administration which had expected a larger output increase to bring down the overall inflation rate.

The future of oil prices is now highly dependent on the flow of Russian oil despite the continuation of the Russia - Ukraine war. With Secretary of Treasury Janet Yellen suggesting that purchasing countries unilaterally decide to pay a much reduced price for Russian oil – a proposed measure incomprehensible to anyone who has studied Supply & Demand 101 – the risk of a partial shutoff of Russian oil supply has risen.

Third, there is history. Recall that the monthly inflation rate decelerated from 0.9% in June 2021 to 0.5% and 0.3% in the next two months, leading monetary officials to go on a victory march. That success was short-lived as inflation accelerated to a peak of 1.3% this June.

Where could renewed price pressure come from besides a possible renewed rise in the price of crude oil? The "food at home" component of the CPI rose by 13.1% over the past year, the largest annual increase since March 1979. The shelter component, though increasing at a slightly slower pace, was still up 0.5% in July compared with 0.6% in June. Expect shelter cost to continue to post large increases as first-time buyers hit by high home prices and elevated mortgage rates move to the rental market.

Fourth, during the same week that CPI and PPI indexes provided some relief, BLS calculations showed that unit labor cost – in my mind, the single best measure of inflation – increased by 10.8% in the second quarter, following an upwardly revised 12.7% rise in the previous quarter. As a result, labor productivity dropped by 4.6% in the latest quarter after a 7.4% fall in the first. Markets took note of the fact that more expensive labor as a factor driving up inflation is here to stay.

Such concerns explain why the yield on 10-year US Treasurys, after falling to 2.71% in the immediate aftermath of the Wednesday inflation report, ended Friday at 2.84%, little changed for the week. By comparison, there was greater optimism among equity investors. Both the S&P 500 index and the NASDAQ posted their fourth successive week of rallies. These investors, in contrast to purchasers of Treasurys, seem to believe that this week's inflation numbers would persuade the Fed to go slow with rate increases – perhaps increase the Federal Funds rate by 50 basis points rather than by 75bp at next month's meeting of the Federal Open Markets Committee.

Some Fed members continue to take the inflation risk seriously. In an interview with the Financial Times, Mary Daly, President of the San Francisco Fed, warned against concluding that the threat of inflation is over. She said after the inflation report Wednesday that she would not rule out a 75bp hike after the Fed met on September 20 and 21.

It is far from certain that the Daly view would be the prevailing one among voting members of the FOMC. However, if Chairman Powell convinces fellow-voters to go easy, as he had done throughout 2021 in believing that inflation was "transitory", we are in for the fight on the price front to become a long-haul one.

Another way of saying it: You can't blame Putin when inflation accelerates, only to take credit for economic policies when it comes down for a transitory period.

Dr. Komal Sri-Kumar


Sri-Kumar Global Strategies, Inc.

Santa Monica, California

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Posted: August 13, 2022 Saturday 10:00 AM